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Melanie Co (Sept/Dec 18)

Melanie Co is considering the acquisition of a new machine with an operating life of three years. The new machine could be leased for three payments of $55,000, payable annually in advance.

Alternatively, the machine could be purchased for $160,000 using a bank loan at a cost of 8% per year. If the machine is purchased, Melanie Co will incur maintenance costs of $8,000 per year, payable at the end of each year of operation. The machine would have a residual value of $40,000 at the end of its three-year life.

Melanie Co's production manager estimates that if maintenance routines were upgraded, the new machine could be operated for a period of four years with maintenance costs increasing to $12,000 per year, payable at the end of each year of operation. If operated for four years, the machine’s residual value would fall to $11,000. Taxation should be ignored.

Required

A. 
(i) Assuming that the new machine is operated for a three-year period, evaluate whether Melanie Co should use leasing or borrowing as a source of finance.
(ii) Using a discount rate of 10%, calculate the equivalent annual cost of purchasing and operating the machine for both three years and four years, and recommend which replacement interval should be adopted.

B. Critically discuss FOUR reasons why NPV is regarded as superior to IRR as an investment appraisal technique.

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